EBITDA add-backs are categories of expenses or losses added back to earnings to calculate covenant EBITDA, the non-GAAP measure that governs leverage, coverage, and debt capacity in private credit. Unlike accounting EBITDA, covenant EBITDA can diverge from operating reality through negotiated adjustments for deal costs, synergies, and non-cash items. In direct lending in private credit, getting those adjustments right is the difference between headroom and a broken covenant.
Add-backs increase EBITDA and, in turn, reduce leverage ratios and expand baskets tied to a percentage of EBITDA. A 10% add-back can lift every EBITDA-based capacity and swing covenant compliance. Therefore, the central question is what qualifies as legitimate and what veers into financial fiction.
The market context has shifted. During the 2020 to 2021 liquidity wave, sponsors pushed aggressive add-backs with thin support. With higher rates and tighter credit, lenders have reasserted discipline. The pendulum moves, but the fundamentals remain the same: documentation beats aspiration, and cash trumps creativity.
Credit agreements embed EBITDA mechanics in several sections, each with different risks. Understanding where definitions live helps you control them.
First, the definitions section sets the foundation through terms like “Consolidated EBITDA,” “Pro Forma Basis,” and “Run-Rate Cost Savings.” These drive leverage tests and restricted payment capacity. When drafting is loose, covenant holes persist for the loan life.
Next, financial covenants reference those definitions for maintenance or incurrence tests. Even in covenant-lite deals, add-backs still affect builder baskets and debt incurrence limits tied to EBITDA multiples.
Then, reporting sections require quarterly compliance certificates with detailed calculations. Experienced lenders reserve review rights, demand backup, and keep the challenge process. The borrower signs, but the lender should own the audit trail.
Finally, evidence standards often appear in other provisions. They typically require good faith determinations that are “reasonably identifiable and factually supportable.” That sounds precise, but without specifics it invites disputes.
Add-backs ease leverage but do not generate cash. Consider a borrower with $300 million of debt and $50 million baseline EBITDA at 6.0x leverage. If the borrower adds $6 million of adjustments, leverage drops to 5.4x. Headroom improves, but liquidity is unchanged.
This disconnect is critical. Interest and amortization require cash, not adjusted earnings. Savvy lenders add liquidity tests and cash dominion triggers that operate independently from EBITDA covenants. Borrowers can inflate adjusted EBITDA, but they cannot print cash.
Moreover, priorities of payment do not change. Aggressive add-backs may fix a future covenant test, but they do not fund payroll, suppliers, or debt service. That truth is often debated in negotiations and then rediscovered in distress.
Non-cash charges form the core of defensible add-backs. Depreciation and amortization are non-cash by definition and measurable under GAAP, so they are standard inclusions.
Stock-based compensation deserves scrutiny. It is a non-cash entry, yet it is a real economic cost. In people-heavy sectors, equity awards replace cash wages. Adding back recurring SBC inflates margins and understates true compensation. Better agreements cap SBC add-backs or require dual presentation showing EBITDA with and without SBC.
Purchase accounting adjustments such as inventory step-ups and acquired intangible amortization are routine, provided they are limited to initial recognition periods. Care is needed to avoid double counting with regular D&A. Where relevant, the interplay with purchase price allocation should be understood and documented.
Transaction costs connected to documented M&A, financing, or reorganizations usually qualify. The operative word is documented – completed deals with invoices, not pipeline hopes. Amortization of debt issuance costs is non-cash, but do not add back both the upfront cash outlay and the later amortization.
Restructuring and integration costs can work with board approval and executable plans. Good evidence includes severance schedules, lease termination agreements, facility closure timelines, duplicative rent during consolidation, and IT migration costs tied to integration.
Pro forma cost savings create the biggest fights and the highest stakes. The standard requires savings that are reasonably identifiable, expected to be realized within a set period, and factually supportable.
Time windows matter. Market terms typically allow 12 to 24 months from transaction close or plan adoption. Longer windows push savings into perpetuity and invite abuse.
Evidence separates credible savings from wishful thinking. Executed vendor renegotiations with new pricing, signed headcount reductions with severance math, and terminated leases with effective dates all support inclusion. Board-approved integration plans with quantified targets and named owners add weight. For context, teams tracking synergy realization often set success criteria upfront to reduce disputes later.
Caps keep EBITDA from becoming a spreadsheet exercise. Caps commonly limit run-rate savings to a percentage of EBITDA and often apply separately to amounts included without realization evidence. Without caps, adjusted EBITDA risks drifting away from performance.
Revenue synergies rarely qualify unless the revenues are contractually locked. Signed cross-sell commitments with minimum volumes can work. Market share projections and pricing optimism usually do not. Where savings are presented in pro forma financial statements, clarity on timing and evidence is essential.
Budget variances and normalized margins are over the line. “What EBITDA would have been” at peak margins is not pro forma, it is imaginary. Lenders should reject margin normalization absent a specific contractual or structural change.
Recurring cost inflation labeled non-recurring fails credibility. Wage increases, utilities, and input inflation are ordinary course unless replaced by contracts at locked rates.
Indefinite initiatives without execution plans do not qualify. Real cost savings require written plans, timelines, owners, and quantified actions.
Double counting is the classic trap. Adding back restructuring costs and also counting those same dollars as run-rate savings may be acceptable if distinct periods and drivers exist, but the same dollar cannot benefit EBITDA twice.
Capital expenditures do not belong in EBITDA. Capex affects free cash flow by design. Companies that capitalize costs to avoid recognizing expense in EBITDA are gaming the system.
Documentation wins arguments and preserves relationships. Board-approved restructuring plans with quantified savings and dates provide the foundation. HR documents for headcount actions and vendor agreements with revised pricing provide proof. A robust quality of earnings report often highlights recurring vs. non-recurring items early in diligence.
Third-party validation can strengthen the case. Consultant synergy studies and procurement diagnostics help quantify opportunities, though they do not guarantee realization.
Monthly tracking schedules that reconcile planned vs. realized savings create accountability and early warnings. They also show good faith efforts to achieve projected benefits and provide a clean audit trail for lender reviews.
Consider a borrower with $300 million net debt and last twelve months GAAP operating income of $35 million. Add $15 million of depreciation and amortization to get baseline EBITDA of $50 million and 6.0x net leverage.
Management proposes $6 million of add-backs: $2 million in integration costs supported by invoices, $1 million of stock-based compensation, and $3 million of run-rate savings from facility consolidation with board approval and executed lease terminations expected within 12 months.
If the credit agreement permits these categories, uses a 12-month window, and caps run-rate savings at 20% of EBITDA, adjusted EBITDA rises to $56 million. Net leverage falls to 5.4x. Interest coverage improves, but liquidity does not, because the add-backs did not create cash.
A practical way to keep add-backs honest is to track their cash conversion. Use a simple measure: Cash Conversion of Add-Backs equals cash realized from the add-backs within 12 months divided by the total add-backs included for that period. If this ratio stays above roughly 70% across quarters, the adjustments are likely grounded in operations. If it falls much lower, you are living on pro forma benefits and risk a liquidity surprise.
EBITDA is non-GAAP in the U.S. and non-IFRS globally, and regulators increasingly police Alternative Performance Measures. In March 2023, the SEC fined a large issuer for misleading non-GAAP adjustments. ESMA emphasized faithful APM labels and consistent definitions in its 2023 enforcement priorities. The UK Financial Reporting Council warned against cherry-picking adjustments in its 2023 thematic review.
IFRS 18, issued in April 2024, requires disclosure of management-defined performance measures with clear reconciliations. That raises the bar for IFRS reporters that access private credit, because weak definitions now have disclosure consequences.
Documentation became aggressive in 2020 to 2021. As rates rose through 2023 and 2024, lenders pushed back on caps, windows, and evidence standards. Credit committees now flag deals where a high percentage of EBITDA comes from run-rate or non-cash add-backs, treating that dependence as credit risk rather than financial engineering. This shift aligns with broader private credit market trends toward tighter underwriting.
Software and SaaS tend to have sizable stock-based compensation and capitalized development costs. Many lenders cap SBC add-backs or require dual EBITDA presentation. Capitalized development costs are cash outflows and thus not EBITDA add-backs.
Healthcare and services often see provider taxes, bad debt provisions, and compliance remediation. These items recur even if labeled non-recurring and usually should not be added back without specific, non-recurring evidence.
Industrial names endure energy and commodity volatility. Unrealized hedge mark-to-market can be neutralized if defined, but realized ineffectiveness and unhedged input spikes are operating costs, not add-backs.
Retailers sometimes run discrete store closure programs that can qualify. Under ASC 842 and IFRS 16, lease accounting creates moving parts, so teams must avoid double counting rent expense versus right-of-use asset depreciation.
Term sheet negotiations should set the headline rules. Decide whether stock-based compensation is included, whether revenue synergies are excluded, and what caps and windows apply to run-rate savings.
Documentation stage requires tight drafting for “Consolidated EBITDA,” “Pro Forma Basis,” and “Run-Rate Cost Savings.” Define evidence standards, specify certification packages, and agree on compliance certificate forms and add-back schedules. If needed, understand how equity cure provisions interact with EBITDA definitions.
Post-close, monthly tracking and quarterly lender updates should show realized versus planned savings. As facts evolve, adjust forecasts and covenant headroom so surprises do not compound.
EBITDA add-backs serve a legitimate purpose when they strip noise and reveal sustainable operating earnings. They become dangerous when they replace operations with aspirations. The contract governs, and evidence wins. In a higher-rate, lower-liquidity market, lenders have the leverage to demand caps, shorter windows, and documentary proof. Borrowers who invest in disciplined add-back governance earn flexibility when it matters most. Above all, remember that add-backs may cure a covenant, but only cash pays the bills.
P.S. – Check out our Premium Resources for more valuable content and tools to help you break into the industry.
